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Sunday, May 4, 2008

The Reserve Status of the Dollar and Gresham's Law

As readers of my blog know, I have been following the debate over the U.S. Dollar's (USD) reserve currency status (here, here, and here). The key question in this debate has been whether the Euro will displace the USD as the main reserve currency going forward. The starting point for these discussion has been the economic profligacy of the United States and whether it, if sustained, is enough to overcome the network externalities currently supporting the USD. Although there is no consensus on this question, here is a fairly standard view compliments of Michael R. Sesit:

It isn't ordained that the dollar surrender its position as the world's go-to currency. Yet if Americans insist on living beyond their means, eschew sound fiscal policies, ignore the greenback's weakness and remain tempted by protectionism, the dollar will in small bites begin to mimic the British pound -- the currency of a once proud but spent imperial power.

Note what this line of reasoning suggests: good money--the Euro--will drive out bad money--the USD. But wait, that runs contrary to the commonly quoted Gresham's Law which says "bad money drives out good money." Is not Gresham's Law one of the great monetary truths we learn in our econ 101 and economic history courses? How could its implications be so off on this issue? George Selgin provides an answer. He tells us that Gresham's Law is not universal:

That bad coins have in fact often tended to drive better coins of the same metal out of circulation is beyond dispute. Yet historical exceptions to this tendency have been observed. Thus even in its narrowest meaning Gresham's Law must be said to hold only under particular conditions. What are these conditions, and why are they crucial?

These questions may best be answered by first considering those exceptional cases in which good coins appear to have driven out bad ones rather than vice versa. The most notable of such exceptions arose in the context of international trade, where, as Robert Mundell (1998) has observed, "strong" currencies, meaning ones that tended to retain their precious metal value over long periods of time, tended to dominate and drive-out "weak" (that is, less reputable) ones: "The florins, ducats and sequins of the Italian city-states did not become ‘dollars of the Middle Ages' because they were bad coins; they were among the best coins ever made." Less well known but equally important exceptions to Gresham's Law involved relatively rare instances of competitive coin production, one example of which was the competitive production of gold coins by private mints in California in the wake of the gold rush. Here as well it was the higher-quality coins that captured the market, allowing their makers to thrive while less reputable private mints failed (Summers 1976).

The main thing that distinguished these exceptions to Gresham's Law from other instances in which the law appears to have applied was the lack of any rules or of any authority capable of enforcing rules compelling people to accept particular coins in payment for goods or in the settlement of debts at some officially designated nominal value. Thus while the California private gold coins were, like those produced at the Philadelphia Mint, denominated in dollars, none of them were legal tender, and people were free to value them as they pleased, or to refuse them altogether. In practice only the better coins gained wide employment because others were not considered to be reliable representatives of the pre-existing dollar unit, and because valuing these inferior coins according to their actual gold content was inconvenient. In the market for international exchange media a similar tendency for good coins to be favored over bad stemmed from the absence of government authorities capable of enforcing legal tender laws and other rules compelling the acceptance of official coins "by tale" (that is, at par or face value, rather than by weight) beyond national borders.

Gresham's Law can hold, on the other hand, where both good and bad coins enjoy similar legal-tender status and where non-trivial sanctions can be applied to persons who insist upon discriminating against bad coin and in favor of good coin. In such cases all coins must be accepted by tale, and the employment of bad coin becomes a dominant strategy in what amounts to a "Prisoners' Dilemma" game in which both sellers and buyers participate. Buyers, knowing that sellers must accept either good and bad coins at their official face value, offer inferior coins, while hoarding, exporting, or reducing better ones; sellers, anticipating buyers' dominant strategy, price their wares accordingly (Selgin 1996)...

[...]

Failure to recognize the dependence of Gresham's Law upon laws interfering with the normal course of voluntary exchange has been responsible for some of the cruder misapplications of the law, including the tendency to treat it as describing the inevitable outcome of any sort of currency competition...

Properly understood, Gresham's Law refers to an unintended consequence of legislation the intention of which is to force people to treat a money they view as inferior as if it were not so...

Gresham's Law, therefore, is limited to money subject to the reach of national laws and does not apply to international reserve currency status. Read the rest of Selgin's article here.

Update: Richard Dutu, Ed Nosal, and Guillaume Rocheteau discuss Gresham's Law in this article. Like Selgin, they note the importance of legal restrictions, but also explain that asymmetric information can play a role. Finally, they indicate that Gresham's Law is less consequential under a fiat money regime. However, they note the following:

Still, there remains one factor that can put Gresham’s law into play today: government interference in the circulation of currencies. In high-inflation countries, when agents are free to choose their medium of exchange, the high inflation currency tends to be displaced by the low-inflation currency. This phenomenon, known as dollarization, is the natural outcome in a currency market with no imperfection. When the government raises the cost of using the low inflation currency, however, agents will be reluctant to use it in transactions and will keep it as a store of value. For instance, legal restrictions on the use of U.S. dollars in countries like Cuba and the former republics of the U.S.S.R have generated an outcome that resembles Gresham’s law. In all these countries, people could be punished for using dollars: Dollars could be confiscated and individuals could be fined. In accordance with Gresham’s law, legal restrictions raise the cost of using dollars and keep bad (domestic) currency circulating widely in these countries.